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FX Implications: US Government shutdown concerns come to the fore

USD index took a breather today after strengthening consecutively following the post-FOMCslump. Nonetheless, USD still manages to mete out a comfortable outperformance against the Antipodean and Scandinavian currencies. Similarly, the Asian currency index (ex-CNY) was largely flat today, in line with shaky equity performance in the region, as US budget talk and potential government shutdown concerns come to the fore. On that note, we maintain thatUSD andJPY are likely to be supported by safe haven flows in the near term because time is running out to resolve outstanding US fiscal issues. Late in yesterday’s New York session, US Treasury Secretary Lew suggested investor confidence that a deal can be struck on the debt limit is “greater than it should be”. The debt limit needs to be increased beforemid-October or the US government could begin to default on its obligations. If market participants begin to price in this scenario, volatility may spike higher and USD and JPY would lift because of their safe haven status. A budget or continuing resolution to fund the US government also needs to be agreed before1 October or the US government will be shut down, including temporarily laying-off public servants. The US government was shutdown in late 1995 and early 1996.

EUR/USD lifted in the early European session by a softer USD, breezing past 1.3510 or 50% retracement of the post-FOMC gains, amidst very light economic news flow. We expect dovish comments from the ECB to continue to cap the pair’s upside. Today the ECB’s Asmussen and Weidmann speak (8am and 11am EST respectively). Various ECB officials that have spoken this week, including President Draghi, have reiterated the ECB’s easing bias. Yesterday ECB Executive Board member Coeure indicated that the ECB is committed to ensuring liquidity will “remain ample”. This adds to Draghi’s comments earlier in the week highlighting the reduction in excess liquidity in the Eurozone banking system. As we outlined yesterday, the reduction inexcess reserves at the ECB and the impact on Eurozone money market rates is a factor that could trigger a policy response from the ECB over coming months. In our view, based on the recent ECB comments the most likely measure would be another Long-Term Refinancing Operation (LTRO). Further dovish comments, particularly from Asmussen would keep mild downward pressure on the EUR. A move back below 1.3400 in EUR/USD is looking likely, driven by the diverging expectations around the ECB and US Fed and the negative German-US two-year yield spread.

AUD andNZD eased as cautious investors turned to safe haven alternatives, and the risks are tilted towards further declines in the near term if US fiscal issues become a prominent driver of currency markets. This is in line with past experiences of acrimonious negotiations over US fiscal issues. AUD and NZD fell significantly when the Standard & Poors credit rating agency cut the US government’s credit rating in 2011. See attached note for a recent review. The Reserve Bank of Australia’s Financial Stability Review (FSR) released today had no direct impact on the AUD. In the FSR the RBA reiterated the Australian banking system’s relative performance and strong profitability. With regards to the property market, the RBA noted the increase in activity over the past year, and that mortgage lenders should retain their high standards going forward. According to the RBA a sustained period of “below-average interest rates could increase speculative activity in the housing market”. On that note, the RBA highlighted the increase in property gearing in self-managed superannuation funds as an area to watch. According to the RBA, this sector “represents a vehicle for potentially speculative demand for property that did not exist in the past”.

NZD continues to underperform. On a trade-weighted basis, the NZD is now close to 2% below its 19 September highs. NZD/USD has now re-traced last week’s FOMC-induced surge. The August New Zealand trade balance released today underwhelmed market expectations. New Zealand recorded a trade deficit of NZ$1.19bn. This was in line with our economists’ expectations (CBA –NZ$1.1bn, market consensus –NZ$0.7bn). The larger trade deficit was driven by a decline in dairy and meat exports. Dairy export volumes fell 8.8% in August, in line with our economists’ expectations given the Fonterra contamination scare that took hold at the beginning of the month. When combined with our firmer USD outlook (see above), NZD/USD may continue to drift down towards 0.8181 (200-day moving average) over the remainder of the week.

AUD/NZD has now lifted by 1.5% from Monday’s lows. The soft New Zealand trade balance has added to the upward momentum in AUD/NZD. While further short-term gains in AUD/NZD are likely, we do not think the rebound in the AUD/NZD cross can be sustained in the medium-term. The diverging outlooks for the RBA and RBNZ remain, and the Australia-New Zealand two-year swap spread remains deeply negative (currently -56bpts). These factors suggest the rally in AUD/NZD may peter out up towards 1.1435 (50-day moving average).

USD/Asia were little changed. The higher-yielding currencies, such asKRW,MYR andIDR, underperformed their regional peers, albeit only modestly comparing to their usual volatility. TheUSD/INR continues to grind down and recouping its recent underperformance after the surprise RBI move. However, in the next six months, the repayment on India’s short-term external borrowing is estimated to be at least USD 40bn on top of its widening current account deficit of USD 20bn on a quarterly basis. By contrast, portfolio and investment inflows have been an average of USD 8bn in the past three years and are unlikely to bridge the funding gap, especially as USD demand could rise on both safe have demand and Fed’s tapering during the same period. We believe the USD/INR could drift higher to 65 levels in coming weeks, as fundamental woes remain. On the other hand, the USD/CNY spot has traded for the past two weeks consistently around 0.5% below its midpoint, indicating the recent onshore CNY demand may have subsided. This could stoke / precede a possible widening to theUSD/CNY trading band in coming weeks.

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